Small-cap favourites

The Weekend Financial Review asked leading small-cap fund managers to nominate higher-quality stocks that are trading near their 52-week high, have upgraded earnings or shown strong operational momentum as their peers struggle and, most importantly, can continue to rally in a bear market. Here are their selections.

1McMillan Shakespeare Avoca Investment Management’s John Campbell favours buying “defensive growth" stocks that can maintain strong earnings growth and are less sensitive to the fortunes of the Australian and global economies. Salary packager and car-lease administrator
McMillan Shakespeare
has many clients in the more defensive health, charitable and government sectors. “McMillan is the No. 1 provider in its space, is well run, has a good service offering and strong potential to further penetrate its key markets," Campbell says. “The market is always concerned the government could change tax rules and reduce the appeal of salary packaging, but we are less concerned by that risk. McMillan shares have had a good run, yet the stock still looks undervalued on our earnings forecasts."

2SAI Global Another defensive growth stock that fits Campbell’s criteria is
SAI Global
, an information provider on risk management, compliance and business improvement. SAI’s information on business standards, regulation and other rules is needed regardless of the state of the economy; if anything, a troubled economy often leads to more rules and regulations. Campbell says: “Compliance is a long-term growth industry and once companies subscribe to such information, it can be hard for them to change to a competing provider. Like McMillan Shakespeare, SAI is also a very systemised business: it can grow without incurring massive upfront fixed costs or extra variable costs. And it still seems good value, even with the share price trading near its 52-week high."

3Navitas Education is another economically less-sensitive industry. If anything, university enrolments increase when unemployment rises as more people study or reskill between jobs. SmallCo’s Rob Hopkins favours
Navitas
, an increasingly global education provider that offers pathway university courses (a bridging course for international students before they enter university), language training, workforce education and student recruitment. Navitas suffered when the federal government clamped down on foreign students who were more interested in getting a visa to stay in Australia than achieving a useful degree. With some restrictions relaxed, Navitas is showing the first signs of stronger student intakes. “There’s more momentum in student enrolments, and Navitas’s US colleges are a fairly immature business with plenty of scope for growth," Hopkins says. “We like that Navitas is reasonably recession-proof because of the education industry’s defensive qualities. The stock is not overly cheap, but has good prospects for medium-term growth."

4Super Retail Group: Investors could have easily avoided
Super Retail
last year and missed a strong rally in its shares. Its $610-million acquisition of Rebel Sport in 2011 had huge questions marks, it faced slowing consumer spending and the Ray’s Outdoors acquisition in 2010 was still being integrated. BT’s Paul Hannan believes
Super Retail
has emerged as one of Australia’s outstanding retailers. “It’s been an exceptional performer against other retail stocks and can continue to be," he says. “We like the company’s mix of growth options: more store rollouts and constant cost and efficiency improvement in the Super Cheap Auto and Boating Camping Fishing businesses, and the big upside from lifting Rebel Sport’s performance. If you look at the history, Super Retail makes a big acquisition every three to five years, beds it down, and uses the cash to fund the next growth project. This strategy creates an operational momentum that can potentially be sustained for years." On Hannan’s forecasts, Super Retail is on a P/E of 13 times 2011-12 earnings and 11 times in 2012-13.

5REA Group Australia’s leading real-estate portal looks a tough buy on two fronts: it trades on a high P/E multiple of about 17 times 2012-13 earnings and a slowing property market means fewer homes for sale and less property advertising. Yet
REA Group
remains a core long-term holding for one of the market’s more astute small-cap investors, the Pengana Emerging Companies Fund. Pengana’s Steve Black believes REA’s main attraction is the continual migration of property advertising from print media to online. Black says: “In 2006, about 9 per cent of real estate advertising was online and this is estimated to have grown now to nearly 40 per cent. Behind this change is about 70 per cent of properties purchased in Australia being first identified on the internet. On that basis, it seems logical to assume over time that advertising spend will continue to migrate online." Black also favours
Amcom Telecommunications
Group, McMillan Shakespeare and
M2 Telecommunications
for their defensive earnings growth qualities.

6Breville Group The provider of small electrical appliances is another well-run company going against the trend. As consumer-products stocks struggle,
Breville
has rallied from a 52-week low of $2.51 to $4.47. Perennial Value Management’s Grant Oshry says Breville has good prospects. “It had a positive earnings revision [in January] and is likely to positively surprise the market when it next reports," he says. “That said, Breville is not a screaming buy as far as valuation goes, given our fair valuation at 11.2 times 2012-13 earnings. But Breville is certainly travelling along better than most."